In Problem 10.38, Mosaic Software could invest $10,000,000 over a 6-year period with a net cash flow estimate of $1,115,000 per year. The equity portion of the investment will cost 9.25% per year; however, the debt portion can vary from 20% to 80% of the total amount, and the required loan rate may change with increasing amounts of debt financing. After an important meeting with the loan officers of the two prime lending banks, the CFO of Mosaic formulated scenarios Bank 1 and Bank 2 for funding the project with different D-E mixes. Using a spreadsheet, develop the WACC curves using a spreadsheet for each scenario and determine if the project is economically justified based on equity financing provided the MARR is set equal to the WACC (a) for the D-E mix of 50%–50%, and (b) for
each funding scenario.
Problem 10.38
Mosaic Software has an opportunity to invest $10,000,000 in a new engineering remote-control system for offshore drilling platforms in partnership with two other companies. Financing for Mosaic will be split between common stock sales ($5,000,000) and a loan with an 8% per year interest rate. Mosaic’s share of the annual net cash flow is estimated to be $1,115,000 for each of the next 6 years. Mosaic is about to initiate CAPM as its common stock evaluation model. Recent analysis shows that it has a volatility rating of 1.05 and is paying a premium of 5% common stock dividend. Risk-free government bond investments are currently paying 4% per year. Is the venture financially attractive if the MARR equals (a) the cost of equity capital, and (b) the WACC? (Note: Refer to problem 10.52 for further analysis of this investment opportunity.)
(a) Project i* = 9.012% for the 50-50 D-E mix, where $5,000,000 in equity is required. (See cells F6 and K6).
Project justified, since i* = 9.012% > MARR = 8.625%
(b) Project i* values on equity basis are shown in columns F and K. The results are the same for both banks and varying loan rates for increasing debt percentages.
First three D-E mixes (equity of 80%, 70%, and 60%) indicate that the project is not justified. For lower equity percentages, the project is justified.
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